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CommentaryC.D. Howe Institute

w w w . c d h o w e . o r g I S S N 0 8 2 4 - 8 0 0 1N o . 2 3 9 , S e p t e m b e r 2 0 0 6

Jack M. Mintz

In this issue...A new, broadened international survey shows that Canada has theeighth highest effective tax rate on capital among 81 countries. Our sta-tus as a high-tax nation raises concerns about the tax system’s effects onlabour, investment and saving. A Pro-Growth Tax Reform plan isurgently needed.

The 2006 TaxCompetitivenessReport:

Proposals for Pro-Growth Tax Reform

The Study in Brief

The 2006 Tax Competitiveness Report provides a window on how Canada’s tax system ranks against theinternational competition. While the federal and provincial governments have made progress in reducingmarginal income tax rates, the pace of tax reform has been slow, compared to some other developedcountries, like Australia, Finland, Ireland and the Netherlands. Several Nordic countries haveimplemented significant reforms through “dual-income tax systems“ that treat labour and investmentincome differently.

Meanwhile, Canada’s productivity growth has been slow, and so has income growth. In the yearsto come, achieving better growth may pose stiff challenges, as population aging begins to pinch labourmarkets, making capital investment all the more important.

Canada will need to pay attention to its effective tax rate on investment. As this report shows, ourmarginal rate remains high, and stands at 8th highest among the 81 developed and developing economieswe studied. This report therefore proposes a Pro-Growth Tax Reform plan that would improve how taxestreat people and their work effort, and how taxes treat savings and investment. Among other reforms, itproposes five immediate priorities:

• Lowering clawback rates for income-tested benefits to achieve lower marginal rates for low-incomeearners and seniors.

• Increasing the limits for contributions to pension and RRSP plans, most importantly raising themaximum age from 69 to 73 years and the earned income limit from 18 to 25 percent. Limits fordeductions to RRSPs or a new Tax Pre-Paid Saving Plan would be increased from $22,000 to $32,000 by2010.

• Increasing the tuition fee and education tax credit from about 23 to 40 percent and doubling theamounts transferred to a parent or eligible guardian.

• A further reduction in corporate income tax rates at federal level from 19 to 15 percent by 2010, as wellas action to better match capital cost allowances and economic depreciation rates for assets.

• Removing the withholding tax on arm’s length interest and, in the case of the US-Canada treaty, thewithholding tax on non-arm’s length interest.

Further, provincial governments should aim to lower their marginal tax rates on work, saving andinvestment, particularly capital taxes on businesses and sales taxes on business intermediate purchases andcapital goods. Both federal and provincial governments should also pursue base-broadening measures,such as removing ineffective tax credits, helping offset the revenue cost of tax relief.

The Author of This Issue

Jack M. Mintz is Professor of Business Economics, Rotman School of Management, University of Toronto,and Fellow-in-Residence, C.D. Howe Institute.

* * * * * *

C.D. Howe Institute Commentary©

is a periodic analysis of, and commentary on, current public policy issues. James Fleming

edited the manuscript; Diane King prepared it for publication. As with all Institute publications, the views expressed here are

those of the author and do not necessarily reflect the opinions of the Institute’s members or Board of Directors. Quotation with

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The 2006 Tax Competitiveness Report provides a snapshot of howCanada’s tax system affects labour, investment and saving, which are allcritical to prosperity in the future. While federal and provincialgovernments have made some progress in reducing high marginal tax

rates on incomes, the pace of tax reform has been too slow over the years and farless dramatic than in some countries like Australia, Finland, Ireland and theNetherlands. Canadian federal and provincial governments are not sufficientlyconcerned about tax reform, even though economic restructuring is fundamentallyaltering the world’s commerce. As business activity increases in Asia, industrialcountries, including Canada, must cope with increased competition from abroadas well as with aging populations within. Tax reform is urgent.

Even the latest federal reforms, which have included introducing or expandingspecial preferences and reducing the GST rate from 7 to 6 percent, are out-of-stepwith the general drift to remove taxes on income in favour of consumption taxes.1

Canadians, especially those with modest and low incomes, face very highmarginal tax rates on employment income and saving. As documented below,Canada has the sixth highest effective tax rate on capital investment among 36industrialized and leading developing countries, as well as the eighth highesteffective tax rate on capital when a further 45 developing countries are included inthe comparison.

The lack of tax competitiveness is a serious issue since it makes it difficult forCanada to achieve stellar economic growth in the face of labour shortages and lowinvestment rates in many industries. For this reason, this report urges majorstructural changes in Canada’s tax system through a Pro-Growth Tax Reform Planthat would improve both efficiency and fairness in the tax system. The plan wouldencompass cuts to high marginal tax rates and introduce a more neutral,simplified approach by removing the tax penalty on saving and eliminatingpreferences for specific activities. One approach to consider is the adoption of aversion of the Nordic “dual income tax,“ with a sharp reduction in taxes oninterest, dividends, capital gains and corporate income to a combined federal-provincial rate of 23 percent. While this is an attractive idea, the approach needsmore careful study.

Although a number of recommendations are made for reforms, five fiscallyresponsible tax reforms could be easier priorities for now at the federal level.These include the following:

C.D. Howe Institute Commentary 1

* I wish to thank Duanjie Chen, Tina Lee and Finn Poschmann for their assistance with tables andgraphs. I am grateful for the many comments received from members of the Tax CompetitivenessCouncil at the C.D. Howe Institute that helped improve the content of the paper, especially fromRichard Bird, Yvan Guillemette, Jon Kesselman, John Lester, Bill Molson, Finn Poschmann andBill Robson. Support for the multi-country comparison of effective tax rates on capital wasprovided by the Foreign Investment Advisory Service, the World Bank, and Deloitte & Touche,which is gratefully acknowledged.

1 If federal sales tax cuts were used as part of a policy to encourage provinces to convert their retailsales taxes into value-added taxes, typically found in most countries, the reductions couldprovide a happier outcome in terms of overall tax reform. A further cut in the federal GST from 6to 5 percent will perhaps help accommodate provincial sales tax reforms.

• The pooling of clawback rates for income-tested benefits to achieve lowermarginal rates for low-income earners and seniors.

• Increasing the limits for contributions to pension and RRSP plans, mostimportantly raising the maximum age from 69 to 73 years and the earnedincome limitation from 18 to 25 percent. Limits for deductions to RRSPs ora new Tax Pre-Paid Saving Plan should be increased from $22,000 to$32,000 by 2010.

• Increasing the tuition fee and education tax credit from about 23 to 40percent and doubling the amounts transferred to a parent or eligibleguardian.

• A further reduction in corporate income tax rates at the federal level from19 to 15 percent by 2010, as well as action to better match capital costallowances and economic depreciation rates for assets.

• Removing the withholding tax on arm’s length interest and, in the case ofthe US-Canada treaty, the withholding tax on non-arm’s length interest.

Provincial governments should aim to lower their marginal tax rates on work,saving and investment, particularly with respect to capital taxes on businesses andsales taxes on business intermediate purchases and capital goods. Both federal andprovincial governments should also consider several recommended base-broadening measures that would remove ineffective tax credits, thereby helping tocover the cost of tax cuts.

The Challenge of Economic Growth

Although employment has improved since 1997, increasing annually by 1.6percent in terms of hours worked, growth in per capita output has been mediocre.Canada’s labour productivity (output per worker) grew by a paltry 1.6 percentannual rate from 2000 to 2004, compared to 3.6 percent in the United States. There,Americans have experienced an overall decline in hours worked (Statistics Canada2005). Low growth in output per worker translates into a poor performance inCanada’s standard of living. Canada’s growth in per capita GDP has been 24thbest of 29 OECD countries (Poschmann 2006). Canadian GDP per capita remainsalmost US$6,500 per capita below that in the US, which for a family of fourindividuals implies a differential of $26,000 in income.

If anything, the challenge to achieve better economic growth will be even moredifficult in the future. More Canadians will retire as the population ages, makinglabour shortages potentially greater (Bourgeois and Debus 2006). While Canadawill continue to rely on immigration to help grow its labour force, it takes timeand cost to integrate immigrants so that they can achieve their full earningpotential. Businesses will continue to shift manufacturing and service productionto Asia where wage costs are much lower, leaving industrialized countries likeCanada the challenge of ensuring their place in worldwide supply chains. Securityconcerns and protectionism, as reflected in the failed Doha round for tradeliberalization, make it more attractive for businesses to locate in large markets likeChina, the European Union and the United States, rather than in a smaller country

2 C.D. Howe Institute Commentary

like Canada, beset with border frictions arising from tariffs, quotas andimmigration laws.

Fortunately, a mix of policies can generate higher economic growth throughbetter use of labour and capital resources. Economic polices that encourage greaterlabour supply, better education and training, infrastructure, capital investment,and the adoption of new technologies can all contribute to better economicperformance (Mintz 2001). Canada has had a relatively successful record in manyrespects, such as improving its quality of education and building goodinfrastructure, especially transportation and communication networks. However,one area of poor performance has been with respect to capital investment flows. InCanada, capital investment has been $3,200 and $1,400 per worker less this yearthan in the United States and the OECD, respectively (Robson and Goldfarb 2006).Without strong business investment, Canada’s growth is restrained, making itmore difficult to innovate, create better-paying jobs and provide the resourcesneeded to support retirement and cover contingencies. The cuts in corporate taxesalone, implemented by federal and provincial governments in 2006, will boostcapital investment by $45 billion in the next five years (Chen and Mintz 2006),increasing Canadian incomes by over $4.5 billion annually.

As discussed in more detail below, taxation reduces economic gains fromwork, investment, saving and risk-taking, thereby undermining a country’s overallcompetitiveness. Non-neutral tax policies that are unevenly applied to variousactivities encourage Canadians to devote resources to less-taxed activities, ratherthan to those that generate the greatest economic returns. High marginal tax rateson those who choose to work or improve their skills discourage labour supply andtraining. Taxes on capital investment and saving reduce the ability of Canadians tocreate sufficient wealth to fund their future needs.

The Current Picture

Taxing People

Canadian federal and provincial governments levy substantial income, payroll,consumption and other taxes as well as pay out transfers that affect the amount ofgoods and services that Canadians can buy, either today or, through their savings,in the future. In 1975, the per capita personal income (prior to the payment oftaxes and receipt of government transfers) was equal to about $6,000 and percapita disposable income (income net of taxes and including governmenttransfers) was equal to $4,900, implying a net tax equal to $1,100 per person, or 18percent of income. Thirty years later, the average personal income of a Canadian isabout $31,500 and disposable income is equal to $24,100 (unadjusted for inflation).Taxes net of income transfers as a percentage of personal income are now 24percent, one-third more than in 1975. This increase reflects the growth ofgovernment spending on goods and services during the period, despite the factthat many public programs such as Medicare and education were already in placeby 1975. Given the rise of both tax levels and transfers, economic distortions


associated with them are therefore even more important today than three decadesago.

The increase in disposable per capita incomes over the last 40 years has beendue in part to inflation, which once removed, measures the growth of both realpersonal income per capita and real personal disposable income per capita overtime (Figure 1). In 1975, disposable personal income was equal to $14,200 (in 1992dollars), rising by almost a third to $18,900 (also in 1992 dollars) in 2005. Duringthis period, government spending increased from 40 percent of GDP to over 50percent by 1992, falling back to about 41 percent today. Total government tax andnon-tax revenues grew from about 37 percent in 1975, peaking at 44 percent in2001, and declining to about 41 percent today.

Even with better fiscal policies in place, as reflected in the slaying of thefederal and most provincial deficits, growth in personal incomes and disposableincomes has been mediocre in the last five years.2 In inflation-adjusted terms, bothmeasures have risen by only $600 per capita from 2001 to 2005, as seen in Figure 1,because taxes net of transfers have remained high as a share of personal incomes.The lack of solid economic growth has therefore affected both people andgovernments — neither the private nor public sectors are gaining resources in percapita terms to spend on tangible private and public services (the latter would


Figure 1: Canadian Real Per Capita Personal Income and Personal Disposable Income

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Source: Statistics Canada, CANSIM.

2 Greater government spending in the past several decades has been accompanied by little changein economic equality as measured by the Gini co-efficient based on after-tax income, inclusive oftransfers. (See Mintz 2001.)

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include spending by governments on goods and services, but not money transferslike social assistance which are netted from taxes). Thus, inadequate economicgrowth has important ramifications since it impedes individuals from buyingconsumer goods and services, and governments from having more money tospend on important public services like education, health and infrastructure.Much more dramatic public policy is needed to improve opportunities foreconomic growth.

Taxing Work

Taxation discourages effort when workers are faced by high marginal tax rates —additional taxes paid on income earned from one more hour worked — thatreduce the financial reward for choosing to take on extra work. As shown in theFigures 2(a) and 2(b) for Ontario and flat-tax Alberta, marginal tax rates approach80 percent for incomes around $37,000 in both provinces. They rarely fall below 60percent for incomes between $28,000 and $50,000 in Ontario and between $30,000to $40,000 in Alberta. Marginal tax rates are high due to the combined effect ofpersonal income taxes, payroll tax (EI and CPP) and clawbacks of federal andprovincial income-tested programs.

High marginal tax rates reduce the incentive to work by encouraging people tocut back their hours employed in favour of more untaxed leisure or homeproduction, although this is offset in part by the desire to work harder as a resultof having less after-tax pay to spend on goods and services. A recent paper using“meta-analysis,“ bringing together 239 results from studies around the world,suggested that a 10 percent increase in the after-tax wage rate encourages a 1 to 2percent increase in hours worked by men and a 5 percent increase in hoursworked by married women (de Mooij, Evers and van Vuuren 2006). Higherincome can also motivate workers to put in more effort for the time they work, afactor which is difficult to observe, especially for entrepreneurs.

High marginal tax rates also encourage individuals to take on tax-planningactivities to avoid tax or to illegally report income.3 Recent Canadian analysis onthe sensitivity of reported income to marginal tax rates tends to show thatreported income can be quite sensitive to tax cuts, especially for self-employedindividuals who have the ability to plan taxes and even evade them (Sillamaa andVeall 2001). Estimates suggest that for employees less than 65 years of age, a 10percent reduction in marginal tax rates causes only an 8 percent increase inreported income, while for self-employed people, taxable income rises by 13percent.4 Reactions also vary across income groups and age, with high-income,younger individuals earning more than $100,000 increasing reported income by 17percent and the high-income elderly increasing reported income by 32 percent inresponse to a 10 percent decrease in marginal tax rates. Sillamaa and Veall (2001)argue that the top revenue-maximizing marginal tax rate is 45 percent, certainly


3 The tax base can increase due to tax cuts reflecting tax avoidance, tax evasion or simply morehours worked or investment.

4 The increased reporting of employment and self-employment income with cuts in marginal taxrates also reflects a shift in the tax base amongst different sources of income.


Figure 2a: Average and Marginal Effective Tax Rates for a Couple with Two Children in Ontario in 2007 allowing for GST and other Refundable Credits

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Source: Source: Finn Poschmann, C.D. Howe Institute, via Statistics Canada’s Social Policy Simulation Databaseand Model, Release 14.1

Figure 2b:Average and Marginal Effective Tax Rates for a Couple with Two Children in Alberta in 2007 allowing for GST and other Refundable Credits

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well below some of the marginal tax rates once taking into account clawbacks,payroll and sale taxes that impact on overall tax levels.

Such high marginal effective tax rates on income also deter people frominvestments in education that improve their future earnings, counteracting theeffect of government subsidies on education (Mintz 2001, Collins and Davies2005). While governments have provided significant subsidies towards education,they have undermined their programs with a tax system that takes away thebenefits of acquiring more knowledge. Tuition and education costs reduce taxpayments of students or their parents by about one quarter. Yet, educationimproves incomes that are taxed in later years at marginal rates almost double themarginal rate for tax credits. The income tax system therefore penalizes theacquisition of education, countering the impact of subsidies.

The steep increase in average tax rates (taxes divided by income received),which rise to almost 33 percent on $30,000 of income, also significantly deterssome from participating in the labour force. When average tax rates are high atlow income levels, individuals may prefer to stop work altogether, opting insteadfor EI benefits or untaxed provincial welfare benefits. Alternatively, they maychoose to participate in the underground economy to avoid paying tax or takemore leisure (which is one gainful activity that is untaxed).

Given the increased labour shortages appearing in many parts of Canada, thesteeply rising average and marginal tax rates should set off alarm bells forpoliticians to look more deeply at taxation with a view to encouraging greaterlabour supply.

Taxing Saving

Under the current tax system, income earned from saving is fully taxed in the caseof interest and rental income. Dividends are taxed at a lower personal rate becauseindividuals receive a tax credit to offset the corporate tax on profits prior to thedistribution of profit. Only one-half of capital gains are subject to personaltaxation, bringing the tax rate on capital gain realizations close to the dividend taxrate. (The one-half exclusion roughly recognizes that business taxes have alreadybeen levied on the reinvested profits that cause share values to rise.) Further,investors are able to earn tax-exempt income by investing in pension plans orregistered retirement savings plans (RRSPs) on a limited basis. Individuals mayalso pay no taxes levied on income derived from investments in owner-occupiedprincipal residences5 that are subject to property tax at the provincial or municipallevel.

Canadians who wish to save for their retirement and other contingencies facequite extraordinarily high tax rates on their investments, unless they are able toshelter their income from taxation through pension plans or RRSPs. Even if theamount by which Canadians save is fixed, taxes on investment income reduce theaccumulation of wealth simply by lowering the yield that investors receive from


5 In principle, under a comprehensive income tax, homeowners would pay tax on “imputed”rental income that would be a charge to them for leasing a house. The carrying costs of owningthe home would be deducted. Several European countries have used this approach for taxinghousing under their income tax.

their investments. For example, for a person needing money in 20 years atretirement time, a 40 percent tax rate on the return on investments (assumed equalto 5 percent), reduces the amount of capital available for retirement after 20 yearsby 33 percent, in current dollars, and by close to 55 percent, once adjusting for 2percent inflation. With inflation and taxes, some investors earn a return on theirsaving that actually reduces the purchasing power of their initial investment — agovernment bond yielding a 4 percent return, subject to a tax rate of 60 percent,provides a yield of -0.4 percent, once adjusting for 2 percent inflation. When taxeseliminate investment income earned altogether, once adjusted for inflation, thepunitive tax rates lead to effective wealth expropriation.

While it is important to keep in mind that taxes lower the amount of wealthavailable at retirement, they also influence the income Canadians are willing toinvest rather than consume. Taxes that reduce the return on saving are unfair tosavers who pay more tax over their lifetime than those who consume theirearnings immediately. A tax on saving increases the price of future consumptionrelative to current consumption because investors are rewarded less for theirwillingness to postpone consumption to future dates.6 Various economic studieshave shown that a 10 percent increase in the return on savings would increasesaving by only 4 percent (Engen, Gravelle and Smetters 1997). However, even ifsaving behaviour may not be too responsive to taxes, the reduction in theaccumulation of wealth for retirement purposes remains substantial given the taximposed on investment income, unadjusted for inflation.

Sadly, marginal tax rates on taxable income from saving, totalling $38 billion in2002 with roughly one-third earned by those with income less than $50,000 peryear,7 are exceptionally high (Figures 3(a) and 3(b)). Federal and Ontariocombined marginal tax rates on investment income rarely dip below 40 percentwhile federal-Alberta tax rates more typically range from 30 to 40 percent due tothe Alberta low-rate provincial flat tax. However, marginal tax rates reach 80percent for seniors with modest incomes of $15,000, both in Ontario and flat-taxAlberta. Even though Canada has developed a better tax system for seniors inrecent years, this potential expropriation of wealth at high marginal tax rates is ablot on the tax system for seniors trying to keep up with inflation.

With pension plans and RRSPs, Canadians can avoid punitive tax rates ontheir investment income since they need not pay tax on income accruing in the


6 On the other hand, taxes also reduce income available for current and future consumption andtherefore encourage people to save more to make up for the loss of future consumption. Targetsavers looking for a particular level of retirement income could increase savings with highertaxes on investment income since they need more investments to make up for the loss in income.

7 See Income Statistics 2004, Taxable Returns by Income Classes, at www.cra.gc.ca. Taxable incomeon saving includes $19 billion in taxable dividends (adjusted downward to reflect the gross-up of125% on dividends), $14 billion in investment income, $3 billion in rental income and $7 billion intaxable capital gains. Amounts were reduced by interest and carrying charges of $3 billion and $2billion in the capital gains deduction. The amount of net investment, rental and taxable capitalgain income earned by those with income less than $50,000 is about $12 billion, roughly one-thirdof the total net income earned on saving. A puzzle is why so much income from saving is subjectto tax when, at the same time, many Canadians do not fully exhaust the contribution room theyhave to contribute to pension and RRSP accounts. In part, this arises from a desire for moreliquidity (since withdrawals are fully taxed if they are needed) and avoiding high marginal taxrates at certain points during their life.


Figure 3a: Average and Marginal Effective Tax Rates for Single Senior in Ontario in 2007,allowing for GST and other Refundable Credits

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Figure 3b:Average and Marginal Effective Tax Rates for Single Senior in Alberta in 2007,allowing for GST and other Refundable Credits

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plan. In 2003, about 8 million taxpayers contributed almost $47 billion to pensionplans and RRSPs (Canada Revenue Agency). They do pay tax upon withdrawalsof interest and principal but they also reduce their taxes when contributing to theplans. So long as the tax rates at times of withdrawal and contribution are thesame, the time value of taxes paid on withdrawals is equal to the tax savings oncontributions. As Shillington (2003) has demonstrated, however, many low-incomeseniors suffer extraordinarily high taxes on the returns from their RRSPs orpensions since the claw back of senior benefits, including the Guaranteed IncomeSupplement, results in much higher taxes paid on withdrawals relative to the taxsavings achieved by making contributions to plans prior to retirement.

Further, many older and upper-middle income Canadians are limited by lawwhen seeking to invest in tax-sheltered savings. Some individuals would like tosave more to ensure they have a similar standard of living upon retirement.However, they are unable to contribute more than the limits that are allowed fordeductions from income for tax-sheltered savings (the 2006 limits are the least of18 percent of earned income or $18,000, with the latter rising to $22,000 by 2010).The earned income limitation may make it difficult to achieve their lifetimeobjectives for retirement income because they are less able to over-save in thegood years to make up for bad years in which the 18 percent limitation mightapply to their circumstances. Those who are 69 or over — and still need to save fortheir longer expected lives or to leave some capital to heirs — are altogetherunable to shelter savings from taxation.

While Canada has built up a good system to encourage the accumulation ofwealth for retirement purposes, the existing tax system is highly unfavourable tosaving that is unsheltered from taxation. The system also limits individuals, in anumber of ways, from fully accessing the pension and RRSP system to avoidpayment of tax on investment income.

Taxing Investment

Business taxes, in the form of levies on corporate income, assets, net worth,purchases of machinery, structures and their components and security trades,lower the return on capital and, hence, the attractiveness of investments. Taxes oncapital investments have the most powerful effect on Canada’s productivity — theability to produce more with the same resources — compared to all other taxes.Without business investment, companies will not be able to improve wages paidto workers since less production is forthcoming from their efforts. Moreimportantly, businesses fail to adopt new innovative technologies to improve theirproducts or processes if they do not invest in capital.

As in the 2005 Tax Competitiveness Report, we provide a ranking of 36industrialized and leading developing economies in terms of their effective taxrates applied to capital investments of multinational corporations. We also providea ranking of 45 additional developing countries.

The effective tax rate is a summary measure indicating the amount of tax paidas a percentage of the pre-tax returns on investment. The measure is based on theassumption that the amount of capital stock invested in an industry is determinedby businesses maximizing their stock market values when investing in machines,


structures, land and inventory. Investment is determined at the level where therisk-adjusted rate of return on capital is at least equal to the cost of capital (Mintz1995). For example, if the risk-adjusted rate of return to capital is 10 percent, a 40percent effective tax rate on capital reduces the rate of return on capital to 6percent. If businesses require at least a 6 percent rate of return (net of risk) tocompensate investors for their willingness to invest in the business, then thecompany will be willing to undertake a new capital project. If the risk-adjustedreturn on projects is less than its cost of capital of 6 percent — say due to taxation— the project will be rejected.

Our calculations take into account corporate income taxes, capital taxes, salestaxes on capital purchases and other capital-related charges like stamp duties,turnover taxes and security transaction taxes for various countries. We assumethat businesses must earn a rate of return on capital sufficient to cover aninternational cost of finance, based on the typical returns required by G-7 countryinvestors who are indifferent to holding bond and stock assets, after adjusting forrisk and personal income taxes. Investments in each country are assumed to havethe same structure of assets, economic depreciation rates and risk-adjusted realrates of return as in Canada. Differences across countries only reflect taxparameters and rates of inflation (that affect nominal interest rates acrosscountries).8

Economic studies have been quite conclusive in recent years in showing thatbusiness taxes significantly affect investment in a country. One recent papersuggests a 10 percent reduction in the cost of capital can increase investment inmachinery and equipment by 10 percent in Canada (Iorwerth and Danforth 2004).McKenzie (2005) finds that a 10 percent increase in the incremental cost ofproduction, inclusive of taxes related to capital and labour, reduces manufacturingestablishments by 3 percent. More powerful results have been obtained by studieson foreign direct investment, showing that a 1 percent reduction in the effectivetax rate on capital can increase foreign direct capital stock by about 3.3 percent (deMooij and Enderveen 2003).

As shown in Table 1a, Canada’s effective tax rate on capital is sixth highestamong industrialized and leading developing economies, following China, Brazil,Germany, Russia and the United States. While this is an improvement over 2005when Canada had the second highest effective tax rate on capital among 36countries, progress is slow, certainly nothing dramatic compared to Irish or Nordicprogress due to tax reforms in recent years (to be further discussed below).

Taking into account the additional 45 countries in Table 1b, only the Republicof Congo and Argentina have higher effective tax rates on capital than Canada,resulting in Canada having the eighth highest effective tax rate on capital in theworld. Canada’s effective tax rate of 36.6 percent is over 6 percentage pointshigher than the average effective tax rate on capital of 30.9 percent, size-weightedacross all 81 countries.


8 Our 2005 estimates in Table 1a above somewhat differ from the 2005 report as we have obtainedbetter information on capital cost allowance rates for some countries as well as some additionalinformation on some taxes. We thank Susan Lyons of Global Services, Deloitte & Touche inWashington DC, for assistance in developing better tax information for a number of the countriesincluded in Table 1. Further assistance was also provided by André Patry at Finance Canada.


Effective Tax Rate on Capital

2006 General CorporateIncome Tax Rate Manufacturing Services 2006 Average 2005 Average

China 24.0 47.5 46.4 46.9 47.2Brazil 34.0 40.0 38.4 38.8 39.1Germany 38.4 39.2 37.7 38.1 36.1US 39.2 34.8 40.2 38.0 36.7Russia 22.0 40.0 36.7 37.6 36.3Canada 34.2 33.1 39.6 36.6 39.1Japan 41.9 36.2 31.2 32.2 30.4France 35.4 33.1 31.9 32.1 33.0Korea 27.5 32.9 31.0 31.5 31.7Spain 35.0 32.0 29.9 30.2 30.3India 33.0 29.2 30.4 30.2 24.6UK 30.0 23.9 29.4 28.5 28.5Iceland 18.0 27.4 25.4 25.7 20.7New Zealand 33.0 31.2 24.1 25.4 25.1Australia 30.0 28.3 22.9 23.6 23.4Italy 37.3 22.0 23.5 23.2 23.4Finland 26.0 22.7 23.1 23.0 24.1Norway 28.0 25.1 21.8 22.3 21.0Netherlands 31.5 23.9 20.0 20.6 23.0Luxembourg 30.4 24.3 20.2 20.5 21.0Greece 32.0 25.4 19.3 20.1 22.4Austria 25.0 21.6 18.5 19.2 20.0Sweden 28.0 19.3 17.5 17.8 14.4Hungary 16.0 19.6 15.6 16.5 17.0Switzerland 16.7 16.4 16.5 16.5 14.1Poland 19.0 15.9 16.4 16.3 28.1Denmark 30.0 18.9 14.8 15.4 16.1Ireland 12.5 12.6 14.6 14.0 17.2Mexico 30.0 18.0 12.8 13.8 15.6Portugal 27.5 15.7 13.4 13.8 13.4Slovak Republic 19.0 14.0 12.2 12.6 10.9Singapore 20.0 7.3 13.1 11.5 10.9Czech Rep 26.0 13.3 10.5 11.2 12.0Hong Kong SAR 17.5 3.6 6.2 6.1 5.8Turkey 30.0 6.9 -2.5 -0.2 5.2Belgium 34.0 -5.9 -4.0 -4.4 23.5

Table 1a: General Corporate Income Tax and Effective Tax Rates on Capital for 2006 and in Comparison to 2005 (in percentages) for 36 Industrial and Leading Developing Countries

Note: The general corporate income tax rate is the statutory tax rate applied to taxable profit of corporations in eachcountry that takes into account both national and sub-national tax rates. The effective tax rate on capital is theamount of corporate income and other capital-related taxes paid by a business as a percentage of pre-tax profitsfor marginal investment projects.


Effective Tax Rate on Capital

2006 General CorporateIncome Tax Rate Manufacturing Services Average

Congo 38.0 42.6 56.7 55.7Argentina 35.0 47.0 43.6 44.3Chad 45.0 37.0 34.2 34.8Pakistan 35.0 30.4 31.4 31.2Iran 25.0 31.4 29.5 30.0Costa Rica 30.0 38.8 29.5 29.7Indonesia 30.0 31.2 27.2 28.7Ethiopia 30.0 31.5 27.3 28.1Tanzania 30.0 27.0 26.1 26.2Tunisia 35.0 25.7 26.0 26.0Botswana 25.0 14.5 26.4 25.6Kenya 30.0 33.1 23.9 25.3Sierra Leone 35.0 14.0 27.2 25.3Lesotho 25.0 11.3 28.0 24.3Uzbekistan 21.8 27.2 22.5 23.7Kazakhstan 30.0 24.5 22.0 22.5Bolivia 25.0 26.0 21.0 22.2Trinidad and Tobago 30.0 5.8 26.2 20.4

Malaysia 28.0 21.4 19.6 20.3Peru 30.0 23.4 18.9 19.8Fiji 31.0 21.5 18.9 19.4Bangladesh 30.0 12.5 21.1 19.4Thailand 30.0 20.7 18.0 19.1Vietnam 28.0 24.4 17.0 19.0Uganda 30.0 9.9 20.1 18.6Georgia 20.0 20.4 17.7 18.2Jamaica 33.3 12.3 18.6 17.7Jordan 25.0 11.4 19.4 17.4Madagascar 30.0 23.4 15.2 17.0South Africa 29.0 17.7 15.3 15.8Rwanda 30.0 21.4 14.5 15.5Mauritius 25.0 8.7 15.8 14.3Morocco 35.0 12.3 13.9 13.6Chile 17.0 13.0 12.0 12.3Egypt 20.0 10.8 12.2 11.9Ghana 25.0 11.1 9.6 9.9Romania 16.0 10.5 8.8 9.3Croatia 20.3 10.9 8.5 9.3Ecuador 25.0 10.0 7.6 8.2Bulgaria 15.0 7.9 7.8 7.8Serbia 10.0 4.6 9.1 7.8Ukraine 25.0 14.2 5.5 7.7Latvia 15.0 6.6 5.5 5.7Zambia 35.0 16.8 -1.3 1.4Nigeria 32.0 5.4 -0.4 0.4

Table 1b: General Corporate Income Tax and Effective Tax Rates on Capital by Country 2006 (in percentages) for 45 Developing Countries

Source: International Tax Program, University of Toronto with assistance from Deloitte & Touche for tax information.

The 2006 reductions in federal and provincial corporate income and capital taxrates caused the effective tax rate on capital to decline by about 2.5 percentagepoints and further reductions planned by 2010, as we detailed in June (Chen andMintz 2006), will result in an effective tax rate on capital equal to 32.6 percent. Thiswill leave Canada with the ninth instead of the eighth highest effective tax rateamong 81 countries. Of course, this assumes that no other changes take place inother countries (an assumption that is already highly unrealistic since severalcountries have announced future business tax reductions).

While Canada’s position has improved relative to a number of other countries,it still has one of most uncompetitive business tax regimes in the world. Althoughother determinants of capital investment, such as the size of the economy (China,Brazil and the United States), infrastructure, the quality the labour force,regulatory practice and a strong rule of law, substantially affect investment,taxation plays a significant role, as studies have shown. For example, it is notsurprising that very low effective tax rates on capital can be found in countriesthat have enjoyed high economic growth rates, including Ireland, Singapore andHong Kong. China, surprisingly, has a high effective tax rate on capital9 but someprovincial governments reduce or negotiate reductions in tax with foreigninvestors for some non-economic benefits, which is not uncommon in manycountries. An example is Canada’s recent support of the auto sector. China’seffective tax rate on capital drops from almost 47 percent to 18 percent whenbusinesses are granted relief from the 17 percent VAT on machinery that isrefunded by some provincial governments.

The above estimates of the effective tax rates for 2006 demonstrate some quiteimportant shifts resulting from tax reforms in a number of countries (as well as anupward trend in forecasted inflation). The most significant tax reform has been inBelgium where the government introduced a notional deduction for the cost ofequity, based on the EU average government bond interest rate. The Belgianeffective tax rate on capital is now negative, implying that the time value of taxdeductions for depreciation, inventory costs and nominal financing costs is morethan the tax that would be paid on income generated by a marginal investment.Any losses incurred on marginal investments in Belgium would need to sheltertaxes on income generated on infra-marginal investments or be carried back orforward to future income earned by the enterprise.

Who Pays the Corporate Tax?

Cuts to business taxes have often been portrayed as unfair, since they arepresumed to benefit the rich who are owners of the corporation, even thoughmany lower-income Canadian own corporate equity through pension plans,RRSPs and mutual fund investments. Nonetheless, business taxes could also bepart of costs, thereby forcing the companies to raise prices that more heavily fallon lower-income Canadians. The taxes could also be shifted back on workers inthe form of lower wages or fewer jobs as the companies are less competitive. With


9 Foreign direct investment in China averaged about 4 percent of GDP from 1997–2004 (WorldBank data).

increased international mobility of capital and Canada having a minute share ofglobal markets, the presumption is that business taxes are less likely to be shiftedonto owners of capital since investors, facing a lower return on capital in Canada,will move their invested funds to foreign jurisdictions where rates of return oncapital are better and they can avoid paying the corporate tax. Instead, it is morelikely to be shifted forward to Canadians through higher domestic prices or lowerwages paid to workers.

Few economic studies are available to provide a clear picture as to who bearsthe corporate tax. Some recent analysis suggests that Canadian capital markets areincreasingly integrated with international markets — thereby suggesting thatcorporate taxes are likely to fall more heavily on workers and consumers —although some segmentation still exists whereby Canadian stock prices seempartly dependent on Canadian saving behaviour.10 With segmented internationalequity markets, Canadian corporate tax policies could reduce equity prices,thereby being in part shifted onto investors. While some evidence has shown thatequity prices of Canadian companies that jointly list on Canadian and foreignstock exchanges seem little sensitive to Canadian tax policy changes, smallbusinesses that are not financed by international markets would be in a betterposition to shift corporate taxes onto their investors. Certainly, corporate levies onsmall businesses allow owners to avoid payment of heavier personal income taxes.Further, the incidence of corporate taxes falls to some extent on foreigngovernments if foreign-controlled businesses, which tend to be large in size, creditCanadian corporate income tax levies against tax liabilities owing to theirgovernments upon repatriation of profits.

To gain some insight into the incidence of corporate taxes, Figure 4 provides ahistorical review of the average corporate tax paid as percentage of profits, as wellas its relation to after-tax book profits, relying on financial statistics provided byStatistics Canada for consolidated balance sheets of larger companies. The averagetax rate differs from the effective tax rates computed above since it calculates taxespaid on all projects, not just the marginal one in the case of effective rates.

From the 1980s until 2003, average corporate tax rates, ranging between 20 and30 percent,11 generally drifted slightly upwards, reflecting tax reform that has ledto broader tax bases and cuts to corporate rates, although the rates are cyclicalwith the business cycle.12 After-tax profits as a percentage of shareholders’ book


10 For example, cuts to dividend taxes in the 1980s and early 1990s caused Canadian equity pricesto increase (McKenzie and Thompson 1996) contrary to a small open economy assumptionwhereby stock market prices are completely independent of Canadian factors affecting Canadianownership of equities. The recent growth of income trusts that has allowed businesses to shift thepayment of corporate taxes to greater personal taxes on Canadian investors would have been lesslikely occur if Canadian markets were fully integrated with international markets.

11 In Graph 4, profits include inter-corporate dividends received from non-consolidatedcorporations that are exempt from taxation in the hands of the recipient corporation since theyhave already been subject to tax prior to their distribution. If the average tax rate is calculated astaxes divided by profits net of dividends received from non-consolidated corporations, theaverage tax rate would be 38.0 percent rather than 26.6 percent during the period 2000–2004.

12 During a downturn, profits are reduced by corporate losses but taxes as a share of profits net oflosses increase since governments do not refund losses unless carried back to reduce taxableincome. During booms, loss carry forwards reduce taxes paid even though income rises and theincidence of losses decline.

equity seem to decline when the average corporate tax rate rises, which could beindicative of businesses making use of prior years’ losses to reduce currentcorporate tax payments during upturns rather than suggesting that corporatetaxes are in part shifted back onto shareholders.13

However, book profit measures are not necessarily related to the marketreturns that investors receive since market values depend on investor expectationsfor future profitability (not current profits) and tolerance toward risk. There arealso distortions arising from inflation and other factors that influence accountingmeasures of book profitability. As an alternative, we examine the relationshipbetween corporate tax rates and a market measure of profitability. The latter canbe tricky to estimate, but we use a five-year rolling average of returns in themarket to smooth out market rates of return to equity. As shown in Figure 4, theafter-tax profitability on shares traded on the TSE has actually declined (incontrast to book profitability) and little relationship can be found between currentor five-year average corporate tax rates and market rates of return to shareholders.This lack of correlation between average tax rates and market-based after-tax ratesof return on equity suggests that it is unlikely that the corporate tax is shifted back


13 A one-point increase in the average corporate tax rate is estimated to lower book after-tax profitrate by 0.34 percentage points, using these calculations. While this could suggest that 35 percentof the corporate tax is shifted back onto shareholders, the correlation also reflects the impact ofbusiness cycles on profit and average tax rates.

Figure 4: The After-Tax Returns on Equity & the Average Corporate Tax Rate

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

Book After-Tax Return on Equity

Tax Rate- Total Taxes as % of Before-TaxProfitsMarket After-Tax Return on Equity

Source: Source: Statistics Canada, CANSIM and Canadian Financial Markets Research Centre Database(http://dc1.chass.utoronto.ca/cfmrc).

Perc

ent

Year

onto shareholders in a significant way, at least in the case of marketable TSEequity securities.

The Need for Pro-Growth Tax Reform

Canada needs a heavy dose of pro-growth structural tax reform that wouldincrease Canadians’ standard of living. It is important to not only consider tax cutsbut also to improve the structure of taxation. This report highlights structuralreforms aimed at the following three objectives:

• Encourage more economic growth: Taxes should be shifted from the current(heavy) impact on labour, investment and saving to tax bases that are lessaffected by taxation. Taxes on mobile capital and labour should be reducedin favour of taxes on consumption, property and other less mobile bases.

• Neutrality: Economic activities should bear similar tax burdens in order toencourage the most profitable use of resources in the economy. Taxes thatvary in burden according to type of good, service or investment encouragehouseholds and businesses to make decisions that yield inferior economicgains in order to lower tax payments. Tax provisions targeted to specificactivities increase administrative and compliance costs for governmentsand taxpayers respectively. Differential tax burdens may be justified ifcertain economic activities should be encouraged (such as research) ordiscouraged (pollution), but only if other alternative policies such asregulations or grants are less effective than tax policy. Otherwise, the besttax system is one that is neutral among taxpayers and various activities tominimize the economic cost of taxation.

• Fairness: Neutral taxes that impose the same burden on taxpayers in similarpositions are most fair. To the extent that some taxpayers have moreresources to pay taxes compared to others, higher taxes should be leviedon those with greater ability to pay taxes. Taxes related to benefits receivedfrom public services are fair to the extent that those who consume theservice pay some of the cost associated with the program.

The Pro-Growth Tax Reform plan is consistent with the approach in recent years,which should involve reducing marginal tax rates on labour and investmentincome, including clawback rates of income-tested programs, removing targetedtax credits, and increasing the use of pension and alternative saving instruments toshelter income from taxation. Corporate taxes should also be reformed bysignificant reductions in corporate income tax rates accompanied by a furtherbroadening of the corporate tax base. Greater reliance on consumption-basedtaxes, including those based on the user-pay principle, such as environmentaltaxes related to the use of clean air and water, should also be included as part ofan overall reform. Tax reform at both federal and provincial levels should aim,therefore, at reducing high marginal tax rates in favour of broader tax bases.


Going Nordic: A Dual Income Tax for Canada?

An innovative but very substantial reform for Canada would be to adopt a dualincome tax, such has become the hallmark of European tax reform in Nordiccountries and the Netherlands (see Sørensen 1994 and Cnossen 2001). Under thedual income tax, portfolio investment income, capital gains and corporate incomewould be taxed at a low rate — even at the lowest tax rate applied to personalincome in some countries. Income from less mobile tax bases (labour) would besubject to higher progressive rates for middle- and upper-income individuals.

This approach to taxing income derived from investments would be asignificant structural change to Canada’s tax system since a major component ofincome — that derived from investment and capital gains — would be taxed on aseparate schedule. It would reduce the need for special preferences like thepension credit, age credit, lifetime capital gains exemption and other preferencesfor capital income. However, for low-income investors, the tax on capital incomecould rise unless some special measures are taken to shelter the investmentincome and capital gains from taxation.

The Nordic countries adopted the dual income tax beginning with a version inDemark in 1987 (with two rates on capital income) and in Sweden (1991). The aimwas to encourage investment, reduce the incentive to shift capital income out ofthe Nordic countries. It was also intended to reduce preferences arising, forexample, from interest deductibility for certain tax-favoured assets such as owner-occupied housing. Interest, dividends, capital gains and corporate income aretaxed at a similar rate, roughly 30 percent or below, with some form of integrationof corporate and personal income taxes on dividends and capital gains in severalof the Nordic countries. Personal tax rates on employment income rise to levels ofat least 50 percent in the Nordic countries.

What would be the features of a dual income tax in Canada? Following theNordic model, the following provisions would apply, based on current income taxrates:

• The progressive rate structure would continue to apply to global incomeexcept for investment income and capital gains that would be subject to aflat tax on a separate schedule.

• The tax rate on investment income and taxable capital gains would be setat a 15.5 percent federal rate and an average 7.5 percent provincial rate fora total flat-tax rate of 23 percent (provincial variation in rates can becomplex to deal with).

• Corporate income tax (using 2010 rates) would be set at an 11 percentfederal rate and a 4 percent provincial rate for a total rate of 15 percent. Asingle tax rate would apply to all corporate income, regardless of industryor size of business. This would remove the need for the two-tier dividendtax credit scheme recently adopted as a result of differential corporateincome tax rates on large and small businesses.

• Corporate and personal income taxes on dividends and capital gainswould be integrated. A single dividend tax credit would be provided toreflect the unified corporate income tax rate of 15 percent. Portfolio


dividends would therefore be taxed at a flat rate of 10 percent and 50percent of portfolio capital gains would be exempt from taxation. Asdiscussed below, a different tax treatment for “participatory“ dividendsand capital gains would be needed for investors closely related to abusiness.

• Interest and other costs incurred for investments would be deductible onlyagainst investment income and taxable capital gains. Losses frominvestments would only be deducted from investment income and capitalgains on a carry-forward and carry-back basis.

• New pension and RRSP assets could be treated as part of investmentincome. A deduction equal to 23 percent of contributions would bepermitted with a tax on withdrawals equal to 23 percent.14 Alternatively,the pension and RRSP assets could continue to be related to employmentincome: contributions deductible and withdrawals taxed as part of non-capital income to help average income for tax purposes.

The Achilles’ heel of dual income tax structures is the problem of delineatingbetween employment and investment income. Those investors who also areemployed or owner-managers of an unincorporated or closely held incorporatedbusiness derive both employment and investment income in the form of salaries,dividends, capital gains, interest and other investment income. The Nordiccountries have developed a distinction between employment and investmentincome by splitting business income into two components: the capital componentequal to the government bond rate plus a risk premium times assets invested inthe business, with the excess being treated as other business income subject to theprogressive rate schedule when paid out to investors and employees. For example,dividends paid to owners from a pool of investment income would be subject tothe flat tax of 23 percent, and the balance subject to the progressive rates. Withfluctuating incomes and complex corporate tax structures, this approach clearlyhas its difficulties, including providing scope to defer taxes owing on personalincome.

Norway recently has adopted a new approach whereby income is splitbetween capital and employment income for individuals rather than at thecorporate level by providing an allowance that is equal to a bond rate multipliedby the investor’s investments, net of borrowings, which would be deducted fromemployment income and added to the investment income account.

Given the importance of the small business sector in Canada, the tax treatmentof unincorporated and incorporated closely held businesses would be a significantissue to consider. One simple approach is to require all income, regardless ofsource, to be treated as employment income if the taxpayer is an employee or hassubstantial participation in a company (such as a minimum ownership of 10percent). An alternative would be the Norwegian approach whereby someinvestors related to the corporation would split income between the employmentand capital income account, although it would require complex record-keeping of


14 This would remove the effect of withdrawals being taxed at either higher or lower rates than thetax rate applied at the time a contribution is deducted from income, effectively removing any taxor subsidy to saving taking into account the time value of money.

assets and liabilities. Individuals with sufficient interest in companies will includedividends and one-half of capital gains as part of employment income with adividend tax credit based on the uniform corporate income tax rate of 15 percent.

A dual-income tax would be a major restructuring of the tax system in Canada.It would reduce the tax penalty on capital investments quite substantially,although it would maintain complexity associated with taxing investment incomeand could result in some taxpayers being more highly taxed than under theexisting system. It is not clear at this time that the dual income tax would be betterthan simply enhancing the retirement saving system and broadening the amountof savings exempt from taxation while lowering overall rates. It is an idea,however, worthy of study.

Pro-Growth Tax Reform

The current Canadian tax system has some very high marginal tax rates onemployment, investment, capital gains and corporate income, especially affectingCanadians with modest income. It is also a hodgepodge of approaches wherebytaxpayers can shelter some or all their savings from taxation by investing inpension plan and RRSP assets, or face quite high effective tax rates on investmentincome when unable to escape the clutches of a government that taxes investmentincome over and above the sheltered savings. While a dual-income tax asdiscussed above would help deal with some of the issues raised in this report, amore comprehensive tax reform is needed.

Reducing Tax Barriers to Work

With increasing labour shortages, tax policies should be aimed at reducing barriersto those wishing to work more, whether in terms of more hours worked, greaterparticipation in the labour force, later retirement or improving the acquisition ofskills. As discussed above, the high marginal tax rates and sharp increases inaverage tax rates at modest income levels especially require more attention.

Several policies could be considered, all of which would reduce tax barriers towork.

• Consolidating Clawback Rates: Reductions in federal and provincial clawbackrates could effectively reduce marginal tax rates that are well in excess of60 percent. One measure would be to avoid the stacking of clawback ratesfor different income-tested benefits: the federal GST and child tax credits,as well as those clawbacks that apply at the provincial level. Federal andprovincial governments could consider creating a pool of credits thatwould be clawed back at a single rate. This would reduce some of thepeaks in marginal tax rates that arise from too many programs that aresubject to different clawback rates, although it would likely spread outclawback rates, albeit at a lower value, for a larger range of incomes.

• Raising the Basic Exemption level: Increasing the basic exemption used todetermine the taxpayer’s credit to a more meaningful amount, such asalmost $15,000 in Alberta, would encourage more people to join the


workforce. For example, those taking a part-time job at $25,000 currentlyface a jump in average tax rates, including payroll taxes, of over 20 percent,which substantially reduces take-home pay.

• More Incentives for Later Retirement: Rules for pension plans and RRSPsshould be revamped to recognize that people expect to live and worklonger in their lives. The existing age limit for contributing earned incometo RRSPs is 69 years, two years less than what was permitted about decadeand a half ago. Given the increase in life expectancy and the need toencourage people to work longer years in an aging society, it would beappropriate to raise the age after which individuals must cease makingcontributions to pensions and RRSPs or are required to withdraw fundsfromany Registered Retirement Income Fund. For example, a new age of 73years would be equivalent to the prior limit of 71 years in the 1980s whenlife expectancies were lower (Mintz and Wilson 2001).

• Reforming Employment Insurance: With recent changes to the EmploymentInsurance system, less incentive has been given to workers to remainworking. Yet, at a time when jobs go begging in many parts of the country,it is illogical that the EI program is not reformed to create better incentivesto keep people engaged in work rather than being laid off. As severalstudies have recommended in the past (see, for example, the TechnicalCommittee on Business Taxation 1998), partial experience-rating fordetermining insurance premiums, already used for workers’ compensationprograms, would reduce the incentive to lay off workers and lowerunemployment rates. Those firms with a record of fewer layoffs would paylower EI premiums. The higher and more-easily claimed benefits paid insome parts of Canada according to the regional rate of unemploymentmake little sense. The focus for determining benefits should be the level ofreplacement income during periods of unemployment not the location ofthe employee. These regionally based benefits should be cancelled,therefore allowing for an overall reduction in EI contributions. As a finalpoint, social programs including compassionate and parental leave, skilldevelopment, job-creation partnerships, targeted wage subsidies andlabour market partnerships should be evaluated as to their effectiveness,whether they should be funded by the EI payroll tax or some other sourceof funding, and whether they should be operated outside the EI programto enable self-employed and other Canadians access to the program ratherthan just those who just qualify for the EI program.

• Reducing the Tax Penalty on Education: Governments should increase thetuition and education credit rate to a higher level such as 40 percent. Thiswould not be as generous as the charitable donation credit, but it wouldreduce the unintended income tax penalty on education and training thatoffsets other government support for education. Further, the amount bywhich the credit can be transferred to a parent should be doubled to$10,000. The existing $5,000 limitation on transfers of tuition and educationcosts to a parent is below average provincial undergraduate costs ofeducation of $5,800 per year, and does not count for differences among


degree tuition levels, provinces, and costs for graduate and specializedprograms.

The above measures would create greater incentive to work and invest ineducation to acquire skills. Given the challenge of rising labour shortages, suchpolicies will become increasingly important over time.

Better Treatment of Savings

While federal and provincial governments have been expanding the limits towhich Canadians can contribute to RRSPs, the progress has been slow andtentative. Without greater personal savings by individuals for retirement,increased demands will be placed on governments to fund pensions and otherretirement benefits with tax dollars that will be more difficult to levy in futureyears on a relatively smaller working population. A number of initiatives could beconsidered that would enhance access to the tax-sheltered savings plans andpermit investors to accumulate wealth more quickly.

Limits should be expanded to allow taxpayers to ensure that they can invest insufficient wealth to replace 70 percent of their income at time of retirement. Basedon current annuity rates and a 5 percent nominal growth rate of earned incomeover 35 years, RRSP and pension plan contribution limits would need to beexpanded to about 35 percent of annual income, or about twice the current limit of18 percent of earned income, to achieve this objective. Indeed, one could argue fornot imposing any other annual limit if the intent of the tax system is to sheltersufficient wealth from taxation so that any Canadian, regardless of income, is ableto achieve a minimum level of replacement income at time of retirement. For now,annual contribution limits should be boosted from $22,000 in 2010 to $32,000(which could include the limit for a new form of retirement savings — TPSPs asdiscussed below) to support greater retirement earnings for upper-income andmiddle-class Canadians. As well, the earned income limit should be increased to25 percent. This is especially important to skilled workers who now enter theworkforce at income levels that are close to, or above, maximum pensionableearnings eligible for pension or RRSP treatment.

Many Canadians do not fully access their contribution room, implying thatthey will have insufficient resources to cover their retirement needs. Canadiansmay be unwilling to invest in pension and RRSP assets since they either do nothave sufficient resources to fund current consumption needs, or do not fullyanticipate the amount of wealth that they require to fund retirement. Further, theincentive to save through pension plans and RRSPs is reduced by otherrestrictions that limit access. Some particular reforms, in addition to the increase inthe age limit for contributions to pension and RRSP earnings as mentioned above,should include the following:

• While Canadians are able to carry forward any unused contribution roomfor pensions and RRSPs to future years, they are unable to increase theircontribution room when withdrawing RRSP funds early to covercontingencies. They therefore lose some of the capacity to fund retirement


when they withdraw funds from RRSPs in early years when they face aneed to do so. To encourage greater use of the retirement system, theunused contribution room should be increased by any withdrawals frompension or RRSP assets.

• Federal and provincial governments should introduce Tax-Prepaid SavingPlans (Kesselman and Poschman 2001) to encourage more retirementsavings. This would allow individuals to better average their tax bases toavoid higher marginal tax rates in the future relative to their currentincome (this applies not just to low-income but to many middle-incomeseniors as well). The TPSPs would permit individuals to earn incomewithin the plan exempt from tax. No tax would be paid upon withdrawaland no deduction would be given for contributions to the plan (interestwould not be deductible for investments in TPSPs, similar to RRSPs). Alimit of $10,000 per taxpayer that would reduce eligible and enhancedRRSP limits, could provide a major boost to saving without a significantupfront revenue cost to governments.

• Low-income Canadians should be encouraged to invest in retirementsavings plans. Withdrawals from plans should not be included indetermining the claw back of income-tested benefits, including GIS andold-age security. At present, such benefits are aggresively taxed back bygovernments through clawbacks.

• While the recent introduction of two dividend tax credits puts corporatesecurities on a more equal footing with income trusts that bypass thecorporate tax, low-tax-bracket or tax-exempt investors still prefer theincome trust structure for investments. For example, when investing withina tax-sheltered RRSP, an investor no longer needs to compare the tax hepays on dividends from a corporation with the tax he pays on income trustdistributions, which are fully taxed as interest income. With the personaltax burden out of the equation, he might well prefer the prospects of anincome trust that pays no corporate tax on profits over a corporation thatdoes so. To ensure equal treatment of all forms of business organizations,the dividend tax credit should be made refundable to low-incometaxpayers, pension plans and RRSP holders to offset fully corporate taxespaid prior to the distribution of income.15 A number of technical issueswould need to be dealt with, particularly with respect to the tax treatmentof foreign owners of income trusts and provincial taxation (Mintz andRichardson 2006).

• Consideration should be given to the introduction of an account thatwould permit investors to roll over marketable assets to defer capital gainstaxes until funds are taken from the account to consume on goods andservices (Mintz and Wilson 2006).

The effect of these provisions would be to boost significantly the amount ofinvestment income sheltered from taxation and help remove the tax penalty onsaving.


15 To ensure that the credit is funded, a minimum tax on dividends against corporate tax paymentsshould be imposed on corporations to ensure that the credit is fully funded at the corporate level.

Improving Canada’s Investment Environment

As discussed above, Canada’s taxation of investment remains quite uncompetitivecompared to most countries and further improvements are needed in thecorporate tax system. The federal and several provincial governments are reducingcorporate taxes, although the progress has clearly been slow. The federalgovernment will drop its general corporate tax rate from 21 to 19 percent, thesmall business rate from 12 to 11 percent and eliminate the surtax of 1.12 percentapplicable to all businesses by 2010. The federal government has also acceleratedthe elimination of the large corporation tax, although capital taxes continue to beapplied to financial institutions, the latter operating as a minimum tax thatreduces corporate income tax payments. Overall, Canada’s corporate income taxwill decline to about 31 percent by 2010, which is three percentage points abovetoday’s world average (KPMG 2006).

Further corporate income tax rate reductions are still in order since they wouldhelp counteract profit-shifting by business to low-taxed jurisdictions as well asimprove the neutrality of the business tax structure. The federal governmentshould consider a reduction in the general corporate income tax rate from 19 to 15percent. Provincial governments should also reduce corporate income tax rateswithout any further reductions in small business tax rates. The current businesstax structure undermines growth by imposing higher taxes on businesses as theygrow. As discussed below, provincial rates should be further reduced as well, sothat the overall statutory tax rates would be somewhat better than the worldaverage. This would create a better environment for investment as well as counterthe incentive to shift profits to foreign jurisdictions.

It would also be important, however, to make the corporate income tax basemore neutral by aligning capital cost allowance rates with economic depreciationrates. Economic depreciation is the loss in the value of assets from year to yearreflecting wear and tear, obsolescence, uncertainty regarding use and inflation.16

As shown in Table 2, the capital cost allowance rates should be boosted on averagefor some assets, especially structures, to match economic depreciation rates. On anasset-by-asset basis, some capital cost allowance rates should be increased andothers reduced.

The federal government could also make Canada more attractive for foreigninvestors by cutting withholding taxes on interest and dividends. Immediateaction should take place that would remove the withholding tax on arm’s lengthinterest and, in treaty negotiation with the US, the withholding tax non-arm’slength interest. Greater effort should be made to update treaties in light of recentUS negotiations that have eliminated withholding taxes on dividends with severalEuropean countries. The federal government should also extend withholding taxrelief to other forms of business organizations such as limited partnerships in


16 Business income is less taxed under inflation if businesses finance their investments with debtsince interest, unadjusted for inflation, is deductible from income. We have shown that, overall,the capital cost allowance rate should be boosted by inflation if debt finance is not too high. Forexample, for pipelines, the capital cost allowance should be boosted by two percentage pointsfrom 8 to 10 percent, reflecting a 50 percent debt-asset ratio and 2 percent rate of inflation for anasset with a life of about 25 years. (Chen and Mintz 2005).

order to encourage their investment in Canada compared to other jurisdictionswhere greater relief is given.

While these changes at the federal level would improve Canada’scompetitiveness, it is even more important for provinces to consider reformingtheir business tax structures (Chen and Mintz 2006). Provincial corporate incometax rates in some provinces, especially the largest one, Ontario, have changedlittle. A number of tax preferences are provided without a proper evaluation ofwhether targeted tax relief is beneficial relative to the economic and compliancecosts that they incur, which is an issue that is especially important in Quebec.Provincial capital taxes remain in many provinces and should be eventuallyeliminated for both non-financial and finacial bussinesses. Tax reform to removesales taxes levied on business inputs should be a significant part of the policyagenda in Ontario, British Columbia, Saskatchewan, Manitoba and Prince EdwardIsland. These provinces should be considering adopting value-added taxes such asthose in Quebec and three Atlantic Provinces. Further, reductions in the federalGST should be used to help pave the way for provincial sales tax reforms.Municipal property tax reform is needed to remove differential taxation of variousforms of business property as well as bring the rates in line with residentialproperty tax rates.

Improving Neutrality and Simplification through Base-Broadening

Tax bases should be broadened, not just rates lowered, in order to improveefficiency, fairness and simplicity in the tax system. Several measures should beadopted that would create more neutrality, improving the efficiency, fairness andsimplicity of the tax system.

Under the personal income tax, several tax preferences should be eliminated.These include the pension income credit, which inappropriately under-taxesincome derived from pension income, given that investors are given a deductionfor contributions to plans when working. The aged credit could also be cut backsince reductions in taxes on investment income would provide significant benefit


Economic Depreciation Rates Average Capital Cost Allowance Rate

Manufacturing

Buildings 9.0% 4.1%

Machinery 20.5% 32.1%

Services

Buildings 6.3% 4.1%

Machinery 31.3% 28.6%

Table 2: Economic Depreciation Rates and Capital Cost Allowance Rates, Averaged by Capital Good Category

Source: International Tax Program, University of Toronto.

to many lower-income seniors.17 The lifetime capital gains exemption —incorrectly viewed as a small business measure because it applies to qualifyingfarm and fishing property and shares in any Canadian-controlled privatecorporation — is abused by those who restructure corporations to take advantageof the exemption. Given that RRSP limits are based on earned income, smallbusiness, farmers and fishers are less able to accumulate savings exempt from tax.They should therefore be provided with enhanced retirement savings plans thatwould allow capital gains upon the sale of their assets to be rolled over into anRRSP on a tax-free basis.

Special credits for labour-sponsored venture capital firms and flow-throughshares for investments in junior oil and gas and mining companies at federal andprovincial levels could be eliminated, along with a number of provincial creditsdirected at savings such as provincial stock savings plans. Such credits encouragelower-quality firms to enter markets, hurting high-quality businesses if investorsview the markets as more risky. This ultimately reduces the efficiency of marketsin the face of uncertainty over the quality of businesses seeking finance (Cumminsand MacIntosh 2006).

Base-broadening under the corporate income tax could also be considered. Thetaxation of international income could be tightened to ensure that Canada is notlosing domestic tax revenue through interest deductions taken against Canadian-source income to help finance investments in other countries.

Research and development tax credits that encourage the supply of researchhave been offset by high taxes on business capital that discourage the demand forresearch. If business taxes are reduced, research and development credits could bescaled back by a quarter since less support would be needed. The differentialbetween small and large business tax credit rates should be eliminated as itencourages employees to quit larger companies to take advantage of the higherresearch and development tax credit available to small businesses. Federal andprovincial investment tax credits of various forms could also be eliminated as taxrates are reduced.

Conclusions

While federal and provincial governments have been improving thecompetitiveness of the Canadian tax system to encourage economic growth andprovide a neutral treatment of various activities, much work still remains to bedone. Marginal tax rates on employment and investment income are excessive,especially for those who have modest income. Canadian businesses are heavilytaxed on their investments — Canada has the sixth highest effective tax rate oncapital among leading economies.

There is much that Canadian governments can do to make the tax system morecompetitive in upcoming budgets. Marginal tax rates on employment andinvestment income can be substantially reduced, especially if more attention is


17 Both the age and pension credits reduce the range by which the GIS is clawed back - theirremoval as credits would need to be considered along with reductions in clawback rates onpension and RRSP withdrawals.

paid to the compounding effects of various federal and provincial clawbacks ofincome-tested programs. Retirement savings could be taxed more lightly bybroadening limits and introducing new approaches to taxing investment income.Corporate income tax rates should be further reduced and capital taxes and salestaxes on capital purchases should be substantially reduced. Tax bases should bebroadened to eliminate preferences for specific activities.

Several immediate reforms could be implemented without substantial revenuecost, as outlined in the introduction. Braver reforms could be considered thatwould create a significant advantage for Canada’s competitiveness. Newapproaches for taxing income should be considered overall, including anexamination of the Nordic dual-income tax structure.


References

Bourgeois, Andreea, and Aneliese Debus. 2006. “Help Wanted: Long-term Vacancies a Major SmallBusiness Challenge.“ Canadian Federation of Independent Business, April, mimeograph.

Chen, Duanjie, and Jack Mintz. 2005. “Canadian Pipeline Construction Cost Considerations forCapital Cost Allowances.“ mimeograph.

———. 2006. “Business Tax Reform: More Progress Needed.“ C. D Howe Institute E-Brief, June 20.

Collins, Kirk A., and James B, Davies 2005, Carrots and Sticks: The Effect of Recent Spending and TaxChanges on the Incentive to Attend University. C. D. Howe Institute Commentary 220. Toronto: C. D. Howe Institute.

Cnossen, Sijbren. 2001. “Tax Policy in the European Union: A review of Issues and Options,“FinanzArchiv 59: 466-558.

Cumming, Douglas D., and Jeffrey G. MacIntosh. 2006. “Crowding Out Private Equity: CanadianEvidence.“ Journal of Business Venturing 20: 569-609.

de Mooij, Ruud A., and Sjef Ederveen. 2003. “Taxation and Foreign Direct Investment: A Synthesis ofEmpirical Research.“ International Tax and Public Finance. 10: 673-93.

de Mooij, Ruud a., Michiel Evers and Daniël J. van Vuuren. 2006. “What Explains the Variation inEstimates of Labour Supply Elasticities,“ Tinbergen Institute, Erasus Universiteit, Rotterdam.

Engen, Gravelle, and Smetters. 1997. “Dynamic Tax Models: Why They Do the Things They Do.“National Tax Journal 50(3): 657-682.

Iorwerth, Aled ab, and Jeff Danforth. 2004. “Is Investment Not Sensitive to its User Cost? The MacroEvidence Revisited.“ Working Paper 2004-05, Ottawa: Department of Finance.

Kesselman, Jonathon, and Finn Poschmann. 2001. A New Option for Retirement Savings: Tax Pre-PaidSavings Plans, C. D. Howe Institute Commentary149. Toronto: C. D. Howe Institute.

KPMG. 2006. Corporate Tax Rate Survey 2006, Switzerland: KPMG International.

McKenzie, Ken. 2005. “Do Taxes Matter to Firm Location?“ manuscript, University of Calgary.

———, and Aileen Thompson. 1996. “The Economic Effects of Dividend Taxation.“ Working Paper96-7. Technical Committee on Business Taxation. Ottawa: Finance Canada.

Mintz, Jack M. 1995. “The Corporation Tax: A Survey.“ Fiscal Studies 16(4): 23-68.

———. 2001. Most Favored Nation: Building a Framework for Smart Economic Policy. Toronto: C. D.Howe Institute.

———, and Stephen Richardson. 2006. “Income Trusts and Integration of Business and InvestorTaxes: A Policy Analysis and Proposal.“ Canadian Tax Journal. 54(2): 359-402..

———, and Tom Roberts. 2006, Running on Empty: A Proposal to Improve City Finances. C. D. HoweInstitute Commentary 226. Toronto: C. D. Howe Institute.

———, and Thomas A. Wilson. 2006. “Removing the Shackles: Deferring Capital Gains Taxes onAsset Rollovers.“ C. D. Howe Institute Backgrounder 94. Toronto: C. D. Howe Institute.

Poschmann, Finn. 2006. “Financial Services Reform: Why Productivity Matters.“ C. D. HoweInstitute E-Brief, June 6.

Robson, W. P., and Danielle Goldfarb. 2006. “Canadian Workers Need Better Tools: Rating Canada’sPerformance in the Global Investment Race,“ C. D Howe Institute E-Brief, June 8.

Sillamaa, Mary-Anne, and Michael R. Veall. 2001. “The Effect of Marginal Tax Rates on TaxableIncome: A Panel Study of the 1988 Tax Flattening in Canada.“ Journal of Public Economics 80(3):341-356.

Shillington, Richard 2003, “New Poverty Traps: Means-Testing and Modest-Income Seniors“ C. D.Howe Backgrounder, No. 65, Toronto: C. D. Howe Institute.

Sørensen, P. B. 1994. “From Global Income Tax to the Dual Income Tax: Recent Tax Reforms in theNordic Countries.“ International Tax and Public Finance 1: 57-79.

Technical Committee on Business Taxation. 1998, Report. Ottawa: Finance Canada.


Recent C.D. Howe Institute Publications

September 2006 Laidler, David. Grasping the Nettles: Clearing the Path to Financial Services Reform in Canada. C.D.Howe Institute Commentary 238.

September 2006 Poschmann, Finn. “Recalibrating the Federal Balance: Federal-Provincial Fiscal Priorities for2006 and Beyond.” C.D. Howe Institute Backgrounder 95.

August 2006 Richards, John, and Mathew Brzozowski. Let’s Walk before We Run: Cautionary Advice onChildcare. C.D. Howe Institute Commentary 237.

Août 2006 Richards, John, and Mathew Brzozowski. Marchons avant de courir: Une mise en garde à proposdes services de garderie. C.D. Howe Institute Commentary 237.

July 2006 Guillemette, Yvan. “Wasting Talent: The Risising Dispersion of Unemployment Rates inCanada.” C.D. Howe Institute e-brief.

July 2006 Goldfarb, Danielle. Too Many Eggs in One Basket? Evaluating Canada’s Need to Diversify Trade.C.D. Howe Institute Commentary 236.

June 2006 Robson, William B.P. “Many Happy Returns: Guarding the Integrity of the CPP InvestmentBoard.” C.D. Howe Institute e-brief.

June 2006 Chen, Duanjie, and Jack M. Mintz. “Business Tax Reform: More Progress Needed.” C.D.Howe Institute e-brief.

June 2006 Robson, William B.P. and Danielle Goldfarb. “Canadian Workers Need Better Tools: RatingCanada's Performance in the Global Investment Race.” C.D. Howe Institute e-brief.

June 2006 Poschmann, Finn. “Federal White Paper Should Address Declining Productivity in FinancialServices.” C.D. Howe Institute e-brief.

June 2006 Dobson, Wendy. The Indian Elephant Sheds its Past: The Implications for Canada. C.D. HoweInstitute Commentary 235.

May 2006 Jaccard, Mark, Nic Rivers, Christopher Bataille, Rose Murphy, John Nyboer and BrynSadownik. Burning Our Money to Warm the Planet: Canada’s Ineffective Efforts to ReduceGreenhouse Gas Emissions. C.D. Howe Institute Commentary 234.

May 2006 Guillemette, Yvan. The Case for Income-Contingent Repayment of Student Loans. C.D. HoweInstitute Commentary 233.

May 2006 Guillemette, Yvan, and William Robson. “Le conte de deux provinces : Le dépassement desdépenses en Ontario et au Québec signale des difficultés budgétaires.” C.D. Howe Institute e-brief.

May 2006 Guillemette, Yvan, and William Robson. “A Tale of Two Provinces: Spending Overruns inOntario and Quebec Spell Fiscal Trouble.” C.D. Howe Institute e-brief.

May 2006 Alexandroff, Alan S. Investor Protection in the NAFTA and Beyond: Private Interest and PublicPurpose. Policy Study 44.

April 2006 Mintz, Jack, and Thomas A. Wilson. “Removing the Shackles: Deferring Capital Gains Taxeson Asset Rollovers.” C.D. Howe Institute Backgrounder 94.

April 2006 Poschmann, Finn, and William B.P. Robson. “Lower Taxes, Focused Spending, StrongerFederation: A Shadow Federal Budget for 2006.” C.D. Howe Institute Backgrounder 93.

April 2006 Poschmann, Finn. “Ready for Relief: There’s More to a Lower GST Than Meets the Eye.” C.D.Howe Institute e-brief.

April 2006 Goldfarb, Danielle, and Stephen Tapp. How Canada Can Improve Its Development Aid: Lessonsfrom Other Aid Agencies. C.D. Howe Institute Commentary 232.

April 2006 Richards, John. Can Aid Work? Thinking about Development Strategy. C.D. Howe InstituteCommentary 231.

March 2006 Robson, William B.P. Beating the Odds: A New Framework for Prudent Federal Budgeting. C.D.Howe Institute Commentary 230.

March 2006 Hart, Michael. Steer or Drift? Taking Charge of Canada-US Regulatory Convergence. C.D. HoweInstitute Commentary 229.

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